Friday, March 30, 2007

I have described borrower-initiated fraud-for-housing loans as “self-underwritten.” The idea is that the borrower knows what the lender’s qualification standards are, knows he doesn’t meet those standards, and knows he cannot negotiate those standards away. His choices are, then, to accept the denial of credit, buy a cheaper house, or to lie or misrepresent the facts of his income, assets, employment, occupancy, and so on such that he appears to meet the standards. I call this “self-underwritten” because it rests on the borrower’s belief that he is a better judge of his prospects for carrying the loan successfully than the lender is; this belief allows him to justify his behavior as something other than criminal.

The fact that there have been so many “self-underwritten” loans in an environment of exceptionally lax standards for lender-underwritten loans is the key to puncturing this self-justification. It isn’t like we’ve had a credit crunch for years perpetuated by extremely risk-averse lenders, so that only perfect borrowers—or those who misrepresent themselves as perfect—can get a mortgage loan. Another way of putting this is that given how ugly so many of the lender-underwritten loans have been lately, there’s reason to think the self-underwritten ones are mostly butt-ugly. I take data on EPD rates for stated-income and zero-down loans, for instance, as some confirmation of this view.

Such a simple-minded perspective on things does, however, beg for additional complexity, and where else would you go for such additional analytic firepower than the New York Times? I offer you a third option: economist-underwritten loans.

A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton, "Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market" (National Bureau of Economic Research Working Paper 12967), shows that the three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans. These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”

The first time I read this I was, actually, so speechless that I could only respond with a quotation from our wise commenter mp: toad bones. Also, dog balls.

After thinking about it overnight, I have come to the conclusion that that’s still the wisest response, but you don’t get a good blog post out of simple incantations. In the “permanent income hypothesis” on which the economist-underwritten loan is based, the borrower’s belief that he will always be able to earn more money in the future, which justifies over-consumption of housing in the present into which he will grow, renders mortgage market “efficient” to the extent that it does away with such artificial constraints as down payment and DTI requirements—which are based on “the amount of money they have right now,” and adopts innovative standards depending on an individual borrower’s confidence in the amount of money he might have in a couple of years.

The evidence for this view is that economist-underwritten loans in the period 1970-2000 didn’t do so badly. Sure, a few of them went down, but it’s important to understand why:

Of course, basing loans on future earnings expectations is riskier than lending money to prime borrowers at 30-year fixed interest rates. That is why interest rates are higher for subprime borrowers and for big mortgages that require little money down. Sometimes the risks flop. Sometimes people even have to sell their properties because they cannot make the numbers work.

The traditional causes of foreclosure, even before there was subprime lending, were job loss, divorce and major medical expenses. And the national foreclosure data seem to suggest that these issues remain paramount. The latest numbers show that foreclosures have been concentrated not in places where real estate bubbles have supposedly been popping, but rather in places whose economies have stagnated — the hurricane-torn communities on the Gulf of Mexico and the industrial Midwest states like Ohio, Michigan and Indiana, where the domestic auto industry has suffered. These do not automatically point to subprime lending as the leading cause of foreclosure problems.

So in this period of happily performing economist-underwritten loans, there were some losers. Apparently the causes, job loss, divorce, and major medical expenses, which could be understood to mean situations in which current expenses are substantially greater than current income—have nothing to say about the idea that it is wise to take a loan that ignores one’s current income and expenses. Lenders, it appears, may consider future income; servicers, it appears, still keep refusing to accept aspirations rather than negotiable instruments to apply to a past-due balance.

Of course it’s not surprising that Goolsbee ignores the evidence of a house-price bubble, since there can apparently be no bubbles in perfect markets. Theories do that to you. But I don’t think theory can really explain the revolting disingenuousness at the end of his op-ed:

The Center for Responsible Lending estimated that in 2005, a majority of home loans to African-Americans and 40 percent of home loans to Hispanics were subprime loans. The existence and spread of subprime lending helps explain the drastic growth of homeownership for these same groups.

According to the Fed report, even after adjusting for differences in the borrower characteristics contained in the HMDA data, African-American and Latino borrowers were more likely to receive higher-rate loans. Furthermore, a recent study released by CRL shows that disparities tend to persist even after additional adjustments were made for differences in credit scores, equity, and other risk factors not available in HMDA data. The Fed authors also adjust for originating lender. Though this adjustment reduces the disparities substantially, significant differences remain. . . .

The CRL study found that, even after controlling for legitimate risk factors, African-American and Latino borrowers were still more likely to receive higher-rate subprime loans than similarly-situated non-Latino white borrowers. With raw disparities in higher-rate loans between groups basically unchanged from 2004 to 2005, there is little reason to believe that legitimate risk factors would account for all of the disparity evident in the 2005 data.

In other words, CRL is suggesting that a pattern of finding subprime loans given to minority borrowers with similar credit, income, and equity profiles to non-Latino whites who get prime loans may imply a certain “inefficiency” in the mortgage market somewhere. For Goolsbee to use this data to buttress an unregulated free-for-all by claiming that it helps out the traditionally disadvantaged is, well, dishonest.

If you look hard at the data compiled by folks like CRL, you do have to face the problems inherent in the lender-underwritten mortgage market: when lenders are allowed to apply standards without public review, they certainly can end up applying those standards in a discriminatory fashion. When “reputable lenders” are allowed to exit entirely certain minority markets, leaving them to the tender embrace of the loan sharks, the “innovative” subprime market can quickly become mere predation. I have no beef with anyone who wants to see regulation of lenders to prevent these social evils.

However, if I had to choose between lender-underwritten and economist-underwritten loans? No contest.